Description

Summary: Great Canadian (GC) has completed 2 transformative deals in the past year that give the company a growth profile that could lead to a doubling of EBITDA by 2022. Risk is low as GC will have a virtual monopoly on the development of gaming assets within the Greater Toronto Area (GTA), which has been a wildly underserved market.  If GC trades inline with peers it could be a $65-75 stock.

Company Background: Great Canadian (GC) operates 29 gaming properties (i.e. casino, racetracks, and integrated resorts) in North America. 28 properties are located in Canada and 1 in the US. Historically, the company has generated a large portion of EBITDA (~70% of 2017) from British Columbia. However, going forward GC has unique leverage to the GTA gaming region, and more specifically, to the modernization of gaming facilities in the GTA.

This leverage comes from the fact that GC has recently won the rights to operate and redevelop several properties in the GTA. By way of background, in 2012 the Ontario Lottery & Gaming Corporation (OLG) announced that it was looking to bring in private sector involvement to help modernize its gaming facilities. The government corporation split up the Ontario gaming assets into 8 bundles split by region and began a process to privatize the operation and development of said bundles. GC was selected as the winner of 3 of the 8 bundles, namely the East, GTA and GTA West bundles. Under the process, the operator will be paid a set annual fee to operate the facilities and will collect 70% of Gross Gaming Revenues (GGR) above a threshold amount. By winning these RFP's, the operator is also allowed to modernize the OLG facilities. Historically, the OLG gaming facilities have predominantly been focused on slots. Under the RFP, operators will be able to introduce live table games, amenities, and in certain circumstances also won the right to open brand new casinos within certain regions.

The GTA gaming bundle is the largest of the OLG assets and is comprised of over 4,000 slot machines and 60 tables across 3 facilities: Woodbine, Ajax Downs and Great Blue Heron. GC is operator and 49% owner of the bundle, and is partnered with Brookfield (49%) and Clairvest (2%). The GTA gaming bundle generated over $1bn GGR in 2017, which represents roughly 29% market share in Ontario (defined as province wide GGR)

The GTA West gaming bundle is comprised of over 2,500 slot machines and 60 tables across 4 facilities: Brantford, Mohawk Racetrack, Flamboro Downs and Grand River Raceway. GC is the operator and 55% owner of the bundle, and is partnered with Clairvest (45%). The GTA West bundle generated $460m in GGR in 2017, representing roughly 12% market share in the province.

Where we are today: GC's base business has been very successful. 2017 adj EBITDA was $221m and has grown at a 5yr CAGR of 8.4%. During these 5 years the company had also bought back roughly 20% of shares o/s, which when compounded with the growth in its underlying business led to EPS more than quadrupling from $0.31/sh in 2012 to $1.39/sh in 2017.

2018 has been a transformation year for GC as they started getting contribution from the GTA gaming bundle as of Jan 28, 2018, and the GTA West bundle as of May 1 2018. Putting these packages into context, GC's base business in 2017 generated $1,182m GGR. It’s attributable share of the OLG packages won is over $800m, implying roughly 67% growth from its base business in 2017. It is therefore no surprise that Q2/18 results (full quarter of contribution from GTA and 2 months from GTA West) saw GC's attributable EBITDA increase roughly 48% YoY to $92m.

Normalizing for full contribution from the bundles implies GC's business is now generating roughly $380m of annualized EBITDA.

The opportunity: While these results alone are impressive, the real upside in GC is through the redevelopment of the OLG assets. Basically, the government-run casinos have been undercapitalized for years and now the private sector is being allowed to turn these facilities into full-service casinos with live tables, amenities etc. GC, having won the Woodbine facilities in the GTA bundle, has arguably acquired the crown jewel of Ontario gaming assets. Woodbine has 3k slots and is already a $800m GGR facility. GC has plans to develop the facility into a world class gaming resort that will include 5k slots, 300 tables, 2 hotels, 9 restaurants, a conference center,  4,200 seat entertainment venue and retail complex. Woodbine is located less than 20miles from downtown Toronto and less than 4 miles from Toronto's Pearson airport. Toronto has a population of over 2.8m (that expands to 6.4m when we consider the surrounding suburbs aka the GTA) and receives over 43m tourists a year. Considering the proximity to the downtown core, the Woodbine redevelopment has the potential to be a cash cow.

All told, on a 100% basis GC is planning to spend over $1.3bn to re-develop the Woodbine asset, and a total of $1.5bn to re-develop the GTA bundle. The company has also outlined a $360m Phase 1 plan for the GTA West bundle. This money should be spent over the next several years, with the majority of work completed by the end of 2021. On a net to GC basis, this represents roughly $988m of capex to GC.

To understand the potential upside on redevelopment one has to understand that Toronto and the GTA are an extremely under-served gaming market. This is evidenced by the fact that while GGR's in development markets tend to grow in-line with GDP, Woodbine's GGR has grown at a 5yr CAGR of 5.3% without the introduction of additional gaming machines. Woodbines win/spot/day (i.e. the productivity of each machine) is $686/slot, significantly higher than GC generates at its flagship River Rock casino in BC ($377/slot) or MGM generates at their domestic ex-Vegas facilities (US$303/slot).

Upside from redevelopment: I look at the potential upside from re-development two ways. The first is the potential incremental GGR that the company can generate from expansion. When all is said and done, GC will have added over 11k new playing spots to its Ontario facilities. While it is normal to expect some cannibalization to legacy assets, I want to be overly precautious and say productivity per spot at redeveloped properties will drop in half. On that basis, I calculate total property GGR will increase by over $930m. Assuming a 15% EBITDA/GGR margin, that implies $140m in incremental EBITDA for re-development, of which $75m is net to GC.

The downfall from this approach is that it might be overly punitive in terms of cannibalization and it doesn’t account for the capital that is going into non-gaming development (hotels, restaurants etc), of which GC and its partners get to keep 100% of proceeds (i.e. the government’s only revenue cut is from standard sales tax).

The second approach to valuing redevelopment adjusts for this. Within the casino industry project returns are analyzed on a EBITDA/capex basis. A decent operator will typically generate 10% returns (incremental EBITDA from growth capex) on a project while great operators can generate +20% returns. For example, MGM spent US$1.4bn to build the National Harbour casino resort in Maryland. The casino has only been opened for 20 months but on an LTM basis it has generated US$157m EBITDA, implying over 11% returns. Another example is Las Vegas Sands Bethlehem casino in Pennsylvania. The company spent $720m to build the property and in the first full year of operation (2011) Bethlehem generated $91m of EBITDA, implying 13% year 1 returns. In 2017 the property generated $147m EBITDA, implying a 20% annual return 7 years in.

How has GC’s track-record on redevelopment been? The most recent example of the company’s operational track-record can be seen in the OLG East bundle that it acquired in January 2016. GC paid the government $37m for the assets in and year 1 it generated roughly $22m of EBITDA. The company spent another $41m building a new casino in the region and the first year after it opened GC generated an additional $10m of EBITDA. These numbers imply the company generated 24% returns on the construction of a new casino, and over 40% return on the acquisition and construction of the East bundle.

I don’t think this result is atypical for GC. But again, being conservative let’s assume they can only generate 15% return on re-development capex. Based on its net $988m capex spend, that implies redevelopment could generate an additional $148m of EBITDA for GC.

Taking the average of $75m in approach 1 and $148m in approach 2 implies a potential $100m in incremental EBITDA for GC by 2022.

What is GC worth: To value GC I believe you have to look at 2022 and beyond in order to get the benefit of redevelopment at its assets. The base business today is a $380m EBITDA business that has grown organically at +8% 5yr CAGR. Let’s be conservative and assume it only grows at GDP going forward (2%). By 2022 that would put the base business at roughly $410. Add to that the $100m in EBITDA that can be generated by redeveloping the OLG assets and GC could be a $510m EBITDA business by 2022.

GC has $249m in net debt and will spend $988m in capex over the next 4 years. During that time however the base business will still continue to generate substantial FCF (it should be noted that under its agreements with the BC and Ontario governments, the provinces will reimburse GC 3-5% of annual GGR to pay for maintenance capex. That means that GC’s share of maintenance capex out-of-pocket is very low). Altogether, once construction is complete I estimate GC should exit 2021 with less than $600m of net debt.

At today’s price of $43.77 GC is trading at 6.4x 2022 EBITDA. Casino comparables trade at an average 10x next year’s EBITDA (range is 6-12x). These multiples are similar to what has been paid in M&A transactions, as acquirers have paid an average of 9.0x EBITDA in 12 deals (asset and corporate) that have occurred in the past 2 years.

Valuing GC on year ahead numbers, by 2021 the stock should be discounting the potential run-rate redevelopment. Applying 9x EBITDA to GC’s potential run-rate EBITDA would imply a $65 stock in 2021. This represents a potential 48% return over the next 3 years.

Note, I think these numbers are conservative as I’ve been punitive on my cannibalization, productivity and return assumptions. If I assume GC can earn a 20% return on its capex, at 9x EBITDA that would imply a $75 stock.

The risk: GC is not a name without controversy. Bears make 2 main points on the name 1) GC was complicit in money laundering in BC, and 2) we don’t know the economics of the OLG bundles.

1) Money Laundering: the company’s flasgship casino, River Rock, has been a hotbed of Chinese money laundering in BC. When the NDP government took over from the Liberals they commissioned an independent review of money laundering in BC casinos[1]. The report did not put any blame on GC. Rather, it pointed out that GC’s responsibility was merely to report suspicious activity to the BC Lottery Corporation. That said, the report specifically pointed out that when the BCLC and the Gaming Policy & Enforcement Branch failed to give clear direction to “stop accepting huge amounts of unsourced cash, the head of compliance for GC decided to end it himself.”[2] So not only was GC not complicit in the crime, they actually went above and beyond what was required of them by law.

While that alone should be enough to ease fears, I point to 2 other facts that clearly show the government has cleared GC of any suspicions. The first is a June 2018 announcement[3] that the BCLC renewed all of GC’s BC licenses for 20 years. This is important because 1) historically each casino was renewed 1x1 as the expiry approached, 2) the deal happened at a time when the NDP were in power. The NDP government has blamed its Liberal predecessors for turning a blind eye to money laundering. Therefore, it’s safe to assume the NDP had no preconceived loyalty to GC, and 3) as part of the new 20 year deal the economics to GC were actually increased (GC gets to keep 42.5% of table GGR and 77.5% of poker, up from 40% and 75%, respectively. Slot take was unchanged).

The second is an October 2017 announcement[4] from the OLG that “OLG has confirmed with B.C. and Ontario regulators that Great Canadian is not under a criminal or regulatory investigation in British Columbia or Ontario for illegal activity involving money laundering….kike any gaming operator in Ontario, Great Canadian is registered with the Alcohol and Gaming Commission of Ontario (AGCO).   AGCO performs extensive and independent due diligence into current and past business conduct before registering any gaming operator.”

2) The second risk that bears point out is that we don’t know the economics of the OLG bundles. That’s true.  All that the OLG discloses is that operators get to keep 70% of GGR above a threshold. Bears say that the threshold will increase so materially that it will cause GC and its partners to lose money on redevelopment. While there is no quantitative way to dispute this claim, I’ll point to the fact that on the March 2018 and August 2018 conference calls GC’s CEO said that there was virtually no risk that the company would not meet the threshold. The exact quotes are:

March 2018:

Q: Okay, great. And then I guess I had one more. If I heard you right to the last gentleman's questions, you're already above the management fee or the -- I guess revenue threshold?

A: Yes, so and you know, look, that shouldn't be a surprise to anybody, that's why I'm a little bit surprised if you're mentioning it, I know there is a concept of a fixed cost, reimbursement in each of these Bundles and then also a recovery of your capital and those are partial assist, but frankly, those are nowhere near enough to generate the revenues that I believe any operator would require to not only fund the expenditures of running these assets, but also to generate an appropriate cash flow return for the equity and the time and the risk that's involved. So, it should not be a surprise to anybody that every day we are generating revenues based on that 70% formula.

August 2018:

Q: All right. Thanks. And just one on the threshold, just on the process there. I guess, as it goes up over time, is that a payment that has to go out to the province just to confirm, or is that something that you don't pass it, you don't get anything or is that a payment that essentially has to be made to the government in some extent

A: I think I answered this question a few calls ago, people need to understand that the threshold commitment level is and will be materially lower than the gross gaming revenues under virtually any possible scenario. So the question that you're asking right now is highly, highly, highly improbable, highly improbable, and I think I was specific about that a few quarters ago when the same question was asked. So the concept of having to pay it if it the revenues aren't there is really not I think a relevant concept.

So, unless you think that the 1) GC CEO lied publically on numerous conference calls and 2) experienced operators such as GC and its partners Brookfield (arguably one of the smartest asset investors in the world) were naïve enough to set the threshold too high, I think the risk that the JV will lose money on redevelopment is essentially non-existent.

Management alignment: In order to retain and incentivize management for redevelopment of the properties, the company awarded the CEO 1.04m options and the COO 450k options at the time of closing the GTA and GTA west bundles. The total package represents roughly 2% of total shares outstanding and I believe aligns management with shareholders.

[1]Dirty Money: An Independent Review of Money Laundering in Lower Mainland Casinos conducted for the Attorney General of British Columbia  https://news.gov.bc.ca/files/Gaming_Final_Report.pdf

[2] Dirty Money pg 129

[3] https://gcgaming.com/new-operating-agreements-executed-british-columbia-lottery-corporation/

[4] https://about.olg.ca/olg-statement-regarding-anti-money-laundering-review-in-british-columbia/

Catalyst

Quarterly results from now to 2022 should demonstrate very strong growth and contribution from the OLG assets and redevelopment. 

Consensus numbers will need to move higher